CHAPTER SIX: ANALYSIS OF INFORMATION STRUCTURE ON THE FIANANCIAL MARKET doc

The Importance of Market EfficiencySecurities Laws Affecting Public-Issuers of Securities Securities laws in Canada reflect the belief that there is or should be a strong connection betw

CHAPTER SIX: ANALYSIS OF INFORMATION STRUCTURE ON THE

FIANANCIAL MARKET

The Importance of Market Efficiency

Understanding the If and How the EMH Principal can Affect Shareholder Wealth

• Understanding how securities are valued is important because

these valuation principles provide guidelines to managers how they should manage businesses on behalf of the shareholders.

• It is the legal requirement and managerial responsibility for

managers to act in the owners’ best interest.

• The discount rate that represents shareholder’s required rate of

return is established as a result of benchmark rates in the capital markets such as the Risk-Free Rate (RF) and the market risk

The Importance of Market Efficiency

Three Elements to Market Efficiency

The Importance of Market Efficiency

Informational Efficiency

• Informational Efficiency is the focus of this

chapter.

• The closer the link between actions of

managers and the value of the firm, the more informationally-efficient the capital market.

The Importance of Market Efficiency

Securities Laws Affecting Public-Issuers of Securities

Securities laws in Canada reflect the belief that there is (or should be) a strong connection between information and stock prices and these laws reflect a number of common principles related to parties to transactions and access to information:

– Continuous disclosure of all material information about the firm.

• Publicly-traded firms fulfill this responsibility through publication of annual audited financial statements, unaudited quarterly financial statements, and through timely press releases and announcements of anything that could ‘materially’ affect the share price of the firm.

– Fair and equal treatment of all market participants through disclosure

requirements that ensure all participants have simultaneous access to the

same information about publicly-traded firms.

• The use of cease-trading orders when new information is being released to the

market is an example of how regulators ensure that information is widely disseminated to all market participants before trading is allowed to occur In this way, all market participants are trading on the basis of the same and complete information ensuring that some participants do not have an informational advantage over others.

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Asymmetric Information

• Asymmetric information is when one party to

a transaction has access to more a complete and accurate set of facts than the other party.

– When this condition exists, it is possible for the

party with better information to use that at their own personal gain, and at the expense of the

other.

06/08/2011

Asymmetric Information

An Example – The Used Car!

An example of Asymmetric information from everyday life might be the situation between a buyer and seller of a used car in a private transaction

– The seller has intimate knowledge of recent car history including past owners, collisions, repairs, and problems.

– The buyer (presuming no expertise as a mechanic) has only their limited skills

of observation and investigation to inform their purchase decision.

In the foregoing example, it is possible, in the absence of rules and

regulations, for the seller to take advantage of the buyer because of

information asymmetry This means, the buyer is likely to pay more for

the car than they should! The seller reaps the rewards of superior

information.

In some provinces, before such a transaction can occur, a sellers information package must be obtained from the Ministry of Transportation This package will include an estimate of wholesale and retail price of the used car, and a list of past owners This is an example of government regulation to try

to reduce the information advantage sellers have over buyers.

Disclosure and Market Efficiency

The Asymmetric Information Challenge

• If informational advantages were widely permitted, and if there were a persistent advantage of some market participants over others, the credibility of the markets would be shaken.

• Under such circumstances, many people would choose not to invest in securities, choosing, instead to put their money into managed deposits, or worse, choosing to hide their money under a pillow.

• This would significantly reduce the number of market participants, and the

amounts of money invested in the markets.

• The result would be:

– Less market efficiency – and even fewer willing participants!

– Lower security prices in general

– Infrequent trading of securities

– Increasing ability of one market participant to affect the security price through their actions.

• Ultimately, the capital market would not be able to channel sufficient surplus

funds to underwrite economic activity such as plant expansions, research and

development, etc In the end, companies would lack capital, and increasingly

become inefficient and ineffective in their markets Jobs would be lost and the standard of living of all would decline.

Defining Market Efficiency

What is an Efficient Market?

An Efficient Market …

• Is a market that reacts quickly and relatively accurately to new public information, which results in prices that are correct, on average.

Market Efficiency

Requisite Conditions

For markets to operate efficiently some conditions must exist:

1 A large number of rational, profit-maximizing investors exist, who

actively participate in the market by analyzing, valuing, and trading securities The markets must be competitive, meaning no one

investor can significantly affect the price of the security through their own buying or selling

2 Information is costless and widely available to market participants at

the same time

3 Information arrives randomly and therefore announcements over

time are not serially connected

4 Investors react quickly and fully (and reasonably accurately) to the

new information, which is reflected in stock prices

Efficient Market Hypothesis (EMH)

Defined

The Efficient Market Hypothesis is

• The theory that markets are efficient and

therefore, in its strictest sense, implies that

prices accurately reflect all available

information at any given time.

Efficient Market Hypothesis (EMH)

Weak Form EMH

• The theory that security prices reflect all market data, referring to all past price and volume

trading information.

• Implication:

– If Weak Form efficient, historical trading data will

already be reflected (discounted) in current prices and should be of no value in predicting future price

changes.

Efficient Market Hypothesis (EMH)

Semi-strong Form EMH

• The theory that all publicly known and available information is

reflected in security prices.

• Assumes the weak-form set of information as well as all public

information pertinent to the security such as:

Efficient Market Hypothesis (EMH)

Strong Form EMH

• The theory that stock prices fully reflect all

information, which includes both public and

private information.

• Implications:

– Stock prices are fairly priced.

– It is not possible to use public information to identify over-priced or under-priced stocks

– It is not possible to use insider information to identify over-priced or under-priced stocks

Weak Form EMH

• States that security prices fully reflect all

market data

– All past price and trading volume data

• If markets are weak form efficient historical

trading data will already be reflected in

current prices and should be of no value in

predicting future price changes.

Semi-Strong Form of EMH

• States that all publicly known and available

information is reflected in security prices.

• This includes information about:

– Earnings

– Dividends

– Corporate investments

– Management changes, etc.

• A market that quickly incorporates newly

released information (to the public) is

semi-strong efficient.

Implications of Market Efficiency

• Empirical Evidence suggests:

– Markets reach quickly and relatively accurately to new public information

– Market prices are correct on average

• Markets may not be perfectly efficient, but

they are relatively efficient.

Implications of Market Efficiency

Implications for Investors

1 Technical analysis is not likely to be rewarded.

2 Fundamental analysis is also unlikely to be successful

at generating abnormal profits after transactions costs, research costs and taxes.

3 Active trading strategies are unlikely to outperform

“passive” buy-and-hold strategies…favouring index mutual funds or exchange-traded funds (ETFs)

4 Investors should focus on the basics of good

investing by defining investment goals in terms of expected return and acceptable risk levels.

Implications of Market Efficiency

Implications for Corporate Officers

1 Timing of security issues or share repurchases in

unimportant because prices are correct on average.

2 Management should monitor the price of the

firm’s securities to see whether price changes reflect new information or short-run momentum and/or overreaction.

Executive Compensation

Some further thoughts

• In an effort to align the interests of agents (managers) with those of the principal (shareholders) compensation is often ‘tied’ to stock performance.

• If markets are not ‘efficient’ then that basic premise is violated.

• Stock prices can change because of company-specific reasons as well as systemic reasons

– Why should a manager be rewarded for ‘riding the wave’ of systemic upward movements in all stock prices?

Summary and Conclusions

In this chapter you have learned:

– That an efficient market is one that reacts quickly and relatively

accurately to new information, and therefore its prices are correct on

average.

– That the Efficient Market Hypothesis (EMH) is tested in three forms; weak, semi-strong and strong

– That empirical evidence suggests that markets are reasonably

efficient, but not perfectly so

– Investors and corporate officers should modify their behaviours and expectations in light of the evidence of market efficiency